In February this year, the Prime Minister’s Office found a quick-fix solution for a host of power producers in the country when it ordered government-controlled Coal India Ltd (CIL), a coal-producing monopoly, to sign binding fuel supply agreements (FSAs) within 45 days. At the heart of the “solution” lay CIL’s obligation to meet the coal requirements of power producers, who had made investments running into billions of rupees.
Twenty-nine FSAs have been signed since then. But the crucial question of who foots the bill for high-cost imported coal is being discussed only now — and the answers are by no means clear.
In the intervening period, CIL was forced to fall in line with the directive – which had been questioned by some minority shareholders – and then revisit the FSAs, this time at the behest of state-owned NTPC, India’s largest thermal power generator.
NTPC executives had not been present in the January meeting when some of the country’s most powerful industrialists, from Ratan Tata to Anil Ambani, had prevailed on Prime Minister Manmohan Singh to find a solution to the fuel supply crisis. The problem was precipitated by the fact that CIL’s annual production of 436 million tonnes has been stagnant for the past few years and it was, therefore, not in a position to meet contracts it had signed with power producers.
There were many problems with the agreements but the most contentious was the low penalty for not meeting FSA obligations at just 0.01 per cent of the quantity not supplied. Obviously, this worked in the interest of a listed company like CIL. Despite being a state monopoly, it had to consider the interests of its 10 per cent non-government shareholding. In March, The Children’s Investment Fund (TCI), with a little over one per cent stake, had raised serious objections to the FSAs. But this nominal penalty would scarcely serve the interests of power producers.
A tentative new penalty structure awaiting board approval has not, however, addressed the concerns of either stakeholder group. Under the new proposal, the penalty kicks in if CIL supplies less than 80 per cent of the annual contracted quantity (ACQ). At a supply level between 80 and 65 per cent of the ACQ, the coal producer must pay the power generator a fine of 1.5 per cent of the price. This penalty rises gradually until it hits a steep 40 per cent of the price if the supplies fall below 50 per cent of the ACQ.
There are added layers of complexity to this formula. One is that it is being linked to the power plant’s actual generation or plant load factor (PLF) of 65 per cent. The second is that CIL will take responsibility for supplying beyond 65 per cent of PLF only if all the involved parties agree to import coal and are willing to absorb a higher “pooled” price, that is, a blend of the domestic administered price and the import cost.
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Obviously, this formula works for CIL. As Girish Shirodkar, partner and managing director, India and Pacific, Strategic Decision Group, explains, “If 65 per cent PLF becomes the reference point, CIL will not have to bear a heavy penalty.” He adds that it helps power companies, too, because they will be “assured of at least that much domestic coal”.
True, but there are two, bigger problems for power producers. One is that the proposed formula crimps power plant efficiency. To generate at a PLF higher than 65 per cent, which most generators will obviously want to, means that plants will have to reconfigure their boilers to process imported coal (currently, most power plants have boilers that can take in Indian coal that has a higher ash content).
This may well translate into an increase in non-fuel costs. The implication is that these costs will be difficult to pass on to buyers (that is, the distribution companies) mostly because the latter cannot afford it owing to accumulated losses from distributing power free or at subsidised rates. Generators will find it difficult to do so even for power purchase agreements in which buyers allow higher prices since such price increases are linked to fuel costs only.
The PLF-domestic coal-linked penalty will also hit power producers’ return on equity. That’s because CIL is obliged to sign FSAs only if power producers sign firm purchase agreements with distribution companies. The problem here is that several producers had offered distribution companies lower tariffs on the assumption that they would be able to sell a certain amount of power as merchant sales for which prices are higher. The FSAs, thus, will close the merchant sale option for power producers, a factor that will certainly hit financial projections.
And then, there’s the issue of the price at which coal will be supplied. At current levels of production, CIL may have to import 20 million tonnes (this figure could change depending on how many power plants sign purchase agreements with distributors). This puts the responsibility squarely on CIL for tying up imports, logistics and passing on the price risk.
That is where the issue of price pooling kicks in. This “pooled price” will be charged to all customers without giving those who get their projects off the ground early a first-mover advantage. A study by Emkay Global Financial Services suggests that the proposed supply cut-offs and price pooling will impact JSW Energy and NTPC, whereas relative newcomers like Indiabulls Power and KSK Energy will be among the major gainers.
A CIL executive says given current global prices and import expectations, there will be an average $100 a tonne increase in the price of coal. As a result, the power cost is estimated to rise 6 to 8 paise a unit nationally — for those plants currently running only on domestic coal the price rise will be even higher.
Power producers who sign FSAs, thus, are caught between certainty of supply and the equal certainty of higher costs and lower returns. If they tie themselves into FSAs with CIL, they get the coal but at a price they are unlikely to recover.
The point, however, is that this complex penalty formulation doesn’t really benefit CIL either — and it is likely to remain a sticking point with its minority shareholders. For one, by proposing to tie in supply contracts at 65 per cent PLF means that the coal producer forfeits potential incentives it can earn from supplying beyond that cut-off. “We believe starting FY13, CIL will have to forego Rs 1,000 crore incentives that it earned in FY12,” says Dhananjay Sinha, co-head, institutional research at Emkay.
Besides, with CIL liquidating stocks worth 37 million tonnes in the next two years to meet its FSA obligations, there will be no surplus left for e-auctions, which gave it around over Rs 20,000 crore in revenue last year (e-auction prices were more than 80 per cent the administered price).
It is, of course, another matter that these issues would not have arisen had coal trading been freely allowed. Indeed, it is hard to find any major coal producing company involved in such a complex supply and pooling mechanism. “It is a sign of an inherently socialist mindset. In other countries, the mining industry is free to sell coal. Private companies can buy and sell coal but here it is not possible,” argues Shirodkar.
This problem spirals back into the free and subsidised power that (mostly) state-owned distribution companies are politically pressured to provide. This imposition, in turn, crimps their ability to absorb price rises. With losses of distribution companies at a massive Rs 26,921 crore at the end of March 31, 2011, power generation companies have little room for manoeuvre in terms of raising tariffs as a result of more expensive imported coal.
So, the prime minister’s FSA diktat essentially seeks to solves an endemic problem with a problematic solution.